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The new normal: recent falls in commodity and power prices

Commodity prices have fallen significantly in recent months. After the initial collapse of oil prices at the end of 2014 and early this year, many market forecasters predicted that prices would steadily rise back to their prior levels over the course of the year. This has not been the reality. In fact, oil prices have been submerged below levels experienced back in January, and stretched as low as they were in the global financial crisis of 2009. Coal prices have reached their lowest point in over a decade, while gas and power prices have sunk to their lowest levels since 2010.

The initial descent

In the latter stages of 2014, oil prices declined sharply. On the supply side, consistently high output levels from OPEC--maintaining production at >30mbd--left the global market in a state of oversupply. On the demand side, China, the world's second largest consumer of oil, reported slowing demand. These, in combination with faltering growth in the Eurozone economy, led to global oil demand reaching its lowest level of growth since 2009. Meanwhile, the coal industry was also suffering a slump in prices, where slower growth in both European and Chinese economies and a historic deal between the US and China (which agreed to reduce carbon emissions in an effort to combat climate change) meant that coal demand was slipping. Gas inevitably followed oil prices down. Inevitably, with coal and gas accounting for over 60% of electricity generation, power prices also factored in the declines.

No coming back

Back in January, there were expectations that oil prices would rise steadily back to their prior levels--the IEA was forecasting Brent crude oil prices to average $67.00/bl in Q415. Several factors contributed to sustained low oil prices, notably:

OPEC maintaining high output levels;

the Iranian nuclear deal being struck , which could see oil export sanctions lifted;

resilient US shale oil production; and

turmoil in the Chinese stock market, which has prompted fears over future demand.

OPEC met in Vienna on 5 June to discuss the current state of the oil market. The oil cartel resolved to maintain the 30mbd ceiling, and urged member countries to adhere to it. Since then, OPEC has consistently produced more than 30mbd, which has brought the market into a long-term state of oversupply. More recently, Saudi Arabia has declined an emergency OPEC meeting, with the aim of preventing further price slides, as the country believes its plan to protect market share (from the US) is working, despite this decimating revenues from other OPEC nations.

Iran also reached a deal with the P5+1 group of nations on 14 July to scale back its nuclear programme in return for the lifting of oil export sanctions. Occupying the world's fourth largest proved reserves of crude oil, Iran currently produces one million barrels per day (mb/d) more oil than its current demand. The Iranian oil minister has already stated the country plans to increase output by 500,000 b/d soon after sanctions are lifted.

In addition, a surprisingly resilient US shale industry means the US has been able to withstand low prices for longer than anticipated. Despite this resilience, reports are now suggesting that low prices are beginning to take a more serious toll on US producers, with non-OPEC production growth expected to slow significantly toward the end of 2015 and even decline in 2016, according to the International Energy Agency's (IEA) latestMonthly Oil Market Report.

Finally, on the demand side, China's recent economic downturn has exacerbated the supply-side led problems. With a slowdown in its economy creating demand fears for the commodity, Brent crude oil has fallen low as $43.3/bl in recent weeks, the lowest level since March 2009. Fears over China's impacts on global growth and commodity demand have obviously been impacting wider markets, but it is striking to note the correlation between oil prices and the Shanghai Stock exchange throughout August.

Coal: The forgotten commodity

Coal prices have been on a longer downward trend than oil, and the media hype around recent oil prices falls has taken some attention away from the state of the market. On a historic basis, the falls in coal are more significant than oil, with API 2 prices now at $50.0/t, their lowest levels in over a decade.

Recent falls have been exacerbated by the two key players in the market, the US and China. President Obama's Clean Power Plan, which aims to limit carbon emissions from power plants, is expected to reduce coal demand in the US. In China, demand for coal has fallen as well, with imports for Q115 down 42% year-on-year. The imposition of more stringent environmental regulations and a recent economic slowdown has also driven forecast demand lower. Furthermore, India has experienced an upswing in domestically produced coal, causing Indian coal import growth to be nearly flat. Despite faltering demand, these global factors all make coal cheaper to buy on the markets for those looking to supply in Europe. As a result, spreads in the UK continue to favour coal production over gas by around £4/MWh in winter months and cheap coal in Europe has also aided a renaissance for coal generation in Germany.

In addition, falling oil prices have had a direct impact on coal. Oil is used for various transport and production activities for coal production; consequently, lower oil prices have enabled further declines in coal prices, especially for globally exported coal products.

Gas and power: The final dominos

Falls in oil and coal prices have had significant impacts on the UK power and gas market, with seasonal contracts for both now at their lowest levels since 2010.

Low oil prices have been a key driver of falling NBP gas prices, with as many as 45% of European contracts still oil indexed. In addition, a comfortable LNG supply outlook for the UK has provided additional weight to contracts--gas exports from the UK reached a four-year high in August as LNG supplies from Qatar led to excess supplies being exported to the continent. The annual October 15 gas contract subsequently reached a record low of 41.1p/th in mid-September.

Power prices have been like the final domino in all of this, influenced by declining gas and coal prices. With gas and coal providing more than 60% of the UK's electricity, the annual October 15 power contract fell as low as £41.8/MWh in mid-September. Consequently, generators are becoming less economic to run. At present, it would be uneconomical to build any new CCGT, OCGT or renewable (without subsidies) facilities, as developers would not be able to cover their initial investment costs at current wholesale power prices.

Future price forecasts: Into the unknown

So where next? The domino effect in the market from rapid declines in oil prices has meant increased focus on where future prices may go. Recently, forecast values have been revised downward significantly, as the long-term state of the market has become clearer. Moody's now forecasts Brent crude oil prices to average $55/bl and $65/bl for 2015 and 2016 respectively--down from $60/bl and $70/bl previously. Similarly, the IEA now forecast Brent crude oil at $54/bl and $59/bl for 2015 and 2016 respectively-- down from $57/bl and $75/bl. The most recent revision came from Goldman Sachs, who reduced their 2016 forecast to $49/bl--down from $62/bl.

There has also been much speculation on further declines in gas prices as the LNG market is likely moving into a period of oversupply. A recent report by Morgan Stanley expected global LNG capacity to increase by ~30% in 2018.

An increasingly important factor to look out for is coal to gas switching. If gas prices are to decline further, they will soon reach a point where gas-fired generation becomes more economical than generation from coal. The UK is much closer than other European countries to the coal to gas switching price due to the UK carbon tax, which makes coal fired generation more expensive. When, or if, gas prices reach a level where it is cheaper to generate with gas, CCGT load factors increase, and this should put a floor under gas prices. However, this will depend heavily on coal prices.

Wider ramifications

Significant revisions in price forecasts suggest that low oil prices are here to stay for some time. What we have seen already is the impact low oil prices have elsewhere in the energy sector, especially on UK power and gas prices. Moreover, the implications are not just profound for wholesale costs. The interlinked nature of the UK energy market means recent trends, and future forecasts of low commodities being the new normal, have relevance to the affordability of contracts for difference within the Levy Control Framework, supplier hedging strategies and North Sea oil exploration.